The Power of Compounding

Albert Einstein once said that compounding interest is the most powerful force in the universe. Luckily, you don’t have to be as smart as Albert Einstein to understand this simple, yet very powerful concept.

The wonder of compounding can substantially grow your money over time. The simple idea is that the investor is generating earnings on an asset’s reinvested earnings. In order to work, you will need initial investment, re-investment of earnings, and time. The earlier you start, the more you are able to accelerate the income potential of your original investment. Metaphorically, you can think of compounding interest as a snowball rolling downhill: it is going to get bigger over time as it accumulates more snow along the way.

Example:

Let’s say that you have $10,000 today and you can put it in a savings account that pays 5%. For simplicity purposes, the interest is compounded annually. This means that in a year, you will have $10,500 ($10,000*5%). Now, let’s assume that rather than withdrawing your interest gain of $500, you keep it in there for another year. If you continue to earn the same 5% rate, your investment will grow to $11,025 ($10,500*5%). As you can see, by reinvesting your earnings of $500 with your principal of $10,000 at 5% interest rate, you will be able to generate an additional $25 that you otherwise wouldn’t have if you invested just the principal of $10,000 at 5% in year two. In year three, you will have $11,576 ($11,025*5%). Without compounding interest, at the end of the year three, you would have $11,500 which is $76 ($11,576-$11,500) less than with compounding interest. This might not sound like a lot at the beginning, but it will make a big difference as time passes in the long run.

The Rewards of Starting Saving Early

Let’s consider a hypothetical situation of twin sisters Jessica and Kim. Jessica and Kim just graduated from college at age 25 and they were able to get very good jobs that offered them a $5,000 signing bonus.

Jessica starts saving now

Jessica decided she was going to put $5,000 towards her savings account right away at age 25. The savings account offered Jessica 5% annual interest rate. After 35 years, when Jessica is 60 years old, she will have $27,580.08 ($5,000*[1+5%]^35) in her savings account.

Kim starts saving 10 years later

On the other side, Kim spent her signing bonus when she started working at age 25. After 10 years, when Jennifer was 35, she started worrying about her retirement and decided to put $5,000 towards her savings account at 5% annual interest rate. After 25 years, when Kim is 60 years old, she will have $16,125.50 ($5,000*[1+5%]^25).

Lesson Learned

Jessica is able to make $11,454.58 ($27,580.08-$16,125.50) more than Kim just by starting 10 years earlier. Both Jessica and Kim were able to generate funds by not doing much rather than just letting their money grow with compounding interest. This is a very simple example, but you can imagine how much money you would be able to generate if you have a higher initial investment to start with or if you are putting away a monthly portion of your paycheck towards your savings account that is using compounding interest. If you allow enough time, the power of compounding can do wonders for your financial goals!